Investing in Structured Notes – Risky Diversifying

Any investor who hasn’t heard of investing in structured notes should take a look at the opportunity with a certain level of caution. Structured notes came out shortly before the recession and were hailed as exciting new investments. Structured products are also called market linked investments and are essentially pre-packaged investments that are based on things like commodities, indices, foreign currencies, and a number of other derivatives. They were designed to meet needs that otherwise cannot be met from the more standard financial measures on the market. As such, they are often used as supplement investments to diversify portfolios, cutting down on portfolio risk and taking advantage of current market trends.

The note is financially backed by the issuer. In the event that the issuing firm goes into bankruptcy, the structured note is repaid at a specific rate, and principal protected notes are not insured by the FDIC. A structured investment is not designed to be traded like stock. Think of them more as certificates of deposit that come with a maturity date. Any investor trying to sell a non-mature structured note will suffer a loss due to hedging fees and other charges that put the selling price below the original issue price.

Keep in mind, however, that structured notes are essentially nothing more than investment bank IOUs. They allow you to easily diversify your portfolio, but there are plenty of risks involved, one of which is credit risk. As with any IOU, you don’t actually have the money and there is always the chance of the debt being forfeited by the investment bank. This could mean that the note become worthless, as we’ve seen happen with the structured notes provided by Lehman Brothers. They also lack liquidity which is an important characteristic to have in investing. Prices are calculated by questionable means and much of it is guesswork, which could mean a drastically differently price than the asset value.

The buffered return-enhanced note or BREN is the most common type of structured note. These offer some amount of downside protection but are still considered risky. What’s worse, investing in structured notes is such a complex endeavor that it’s difficult for even the most seasoned investor to grasp. Any investor considering diversifying their portfolio with structure products should do the research thoroughly before jumping in. The illiquidity and credit risk alone may be enough to turn off experienced investors who would rather purchase a more modest CD.

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